How Roy Niederhoffer’s Diversified fund defies the odds

It makes sense that Roy Niederhoffer is an opera fan. His £350m Diversified hedge fund seems to thrive in the heat of the drama, the intensity of a tragic tale. And thrive it has during the COVID crisis — in the year to April 6 it soared 30%, as the US stock market went 27% in the opposite direction. Proof, if it were needed, that Niederhoffer knows more than just his arias from his elbow.

But we shouldn’t be surprised — he’s been here before. In 2000 at the height of the dotcom bubble, that same Diversified fund, the flagship of his New York-based firm RG Niederhoffer Capital Management, returned 60%. As the financial crisis crippled almost everyone in 2008, it rose 51%. This man is a master of the volatile market.

30%

Gains of Roy Niederhoffer's Diversified fund in the year to 6 April

His secret, essentially, is an understanding of cognitive bias — spotting, tracking the human behaviour that makes the markets too fearful or greedy and then, as they correct, buying futures in bonds, stocks and other assets. And to do that you need to realise one thing, he says: “People hate to lose more than they love to win.”

A question of psychology

Niederhoffer showed early business acumen when he was just 14, setting up a computer game design company and selling its products to Sears, K-Mart and Woolworth when he was still at school. He graduated from Harvard in 1987 with a degree in computational neuroscience and had been trading for just three weeks when he saw his first crash, alongside his elder brother, legendary quant trader Victor Niederhoffer.

On Black Monday he saw the possibilities as his brother “lost everything he had by 3pm, and then got it back. It seared into my mind that emotion and psychology can trump fundamentals.”

Six years later he launched the Diversified fund, using data and a recognition that “your brain plays tricks on you” to create a hedge with a short-term contrarian investment strategy. From the outset, he was exploring neural networks to understand that cognitive bias in the human brain that makes it behave predictably — and the more volatile the markets, the more predictably the herd reacts.

All of which means that while most CTAs are defined as following trends, Niederhoffer’s Diversified fund is not one of them. “We try to combine interesting standalone returns with very consistent downside protection for people’s portfolios,” Niederhoffer explains. “We try to maintain a consistent negative correlation to equities – in other words, we do better when equities are in trouble.”

“We try to maintain a consistent negative correlation to equities – in other words, we do better when equities are in trouble” - Roy Niederhoffer

The downside, of course, is when the market is stable. It’s not averse to its own bumpy periods and in a sense, the COVID crisis has rescued Niederhoffer’s from a pretty abject 2019 — six months ago Diversified was lamenting a huge 22% year on year drop. Throughout last year, central bank stimulus meant a calm, controlled and steady rise in asset prices without so much as a wobble, but negative returns for Niederhoffer’s investors.

It’s a strategy very much grounded in data — but using software in a way that identifies and, crucially, anticipates short-term investor responses different from his rivals. “We don’t really look at the relative volumes of selling and buying,” says Niederhoffer. “It’s the path that a price has taken that gives us the information, rather than the level of the stock price itself. If it went down then up, that’s very different from up then down — but it’s vital because that is the way people view the world. It’s how we are relative to where we were that gives us our state of mind.”

Taking on tech

As artificial intelligence and machine learning have gradually risen to the investment fore, the 54-year-old is adamant the key lies in knowing exactly when and how to use these 21st-century tools – and when not to. “We are using various technologies, but there are always caveats,” he says. “You have to be extremely careful. Machine learning is not the Holy Grail in terms of trying to forecast the direction of price in the markets."

He considers that despite the sophistication of quant funds and although computers are “good at figuring things out", Niederhoffer believes it is “fanciful” that computers could trade without the help of humans. “It’s easy to find strategies that appear to predict bull markets exclusively based on bullish sentiment. But this can easily lead to spurious predictions of future market direction – the crashes of 2000 and 1987 underscore this point.”

“It’s easy to find strategies that appear to predict bull markets exclusively based on bullish sentiment. But this can easily lead to spurious predictions of future market direction – the crashes of 2000 and 1987 underscore this point” - Roy Niederhoffer

So Niederhoffer’s risk management committee can step in to protect investments when certain thresholds are breached. “It’s like the way an aircraft flies,” is how he describes his strategy. “Most of the time the plane is on autopilot, and does a great job of flying itself. Every once in a while it’s necessary for the pilot to jump in.”

But while Niederhoffer’s success is about regulating those human emotions, he himself is very passionate about the things he loves — his wife, his children, music and his home city of New York. He can and does improvise, as an accomplished jazz pianist, and he’s a violinist with the Park Avenue Chamber Symphony. And of course, he loves an aria or two and has only recently stepped down as chairman of the New York City Opera.

But even when enjoying those passions, he has a rational eye for the main chance — sometimes entertainingly so. He recently delighted an audience with an after-dinner speech dissection of Bizet’s Carmen, likening its heroine to a “volatile, high-risk investment” which fatefully tempted rash, impulsive Don José to wipe out his entire portfolio, a fate he’d have avoided if only he’d stuck with his stable girlfriend Micaela, whose much more placid temperament offered him “immediate positive returns”.

As for the here and now, Niederhoffer’s expects more 2020 to bring more market volatility — and more opportunity for his strategy to flourish. “The near future,” he predicted last month, “will be much more volatile for a much longer time than we’ve seen before.”

If Niederhoffer’s right, this particular opera has a way to go yet. So long, in fact, that the fat lady hasn’t even started warming up yet….

Investing in CMC Markets derivative products carries significant risks and is not suitable for all investors. You could lose more than your deposits. You do not own, or have any interest in, the underlying assets. We recommend that you seek independent advice and ensure you fully understand the risks involved before trading. Spreads may widen dependent on liquidity and market volatility.

The information on this website is prepared without considering your objectives, financial situation or needs.

Consequently, you should consider the information in light of your objectives, financial situation and needs. CMC Markets Asia Pacific Pty Ltd ABN 11 100 058 213, AFSL No. 238054 (the derivative product issuer), CMC Markets Stockbroking Limited, Participant of the ASX Group (Australian Securities Exchange) and SSX (Sydney Stock Exchange) and Chi-X (Chi-X Australia), ABN 69 081 002 851, AFSL No. 246381 (the stockbroking services provider) provides the financial products and/or services. It's important for you to consider the relevant Product Disclosure Statement ('PDS') and any other relevant CMC Markets Documents before you decide whether or not to acquire any of the financial products. Our Financial Services Guide contains details of our fees and charges. All of these documents are available at cmcmarkets.com.au or you can call us on 1300 303 888.

Apple, iPad, and iPhone are trademarks of Apple Inc., registered in the U.S. and other countries. App Store is a service mark of Apple Inc. Android is a trademark of Google Inc.